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  <h1>Risk characteristics and features</h1>

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   <p>Consider if the new asset could be a diversification from other assets.</p>
   <p> When you are asked to describe the features of a certain kind of asset, you need to address the following features and <span class="highlight"> tailor them to your question.</span>
     <ul>
       <li>
         Security of income and capital
         <ul>
           <li>risk of income
           </li>
           <li>risk of capital
           </li>
           <li>risk of insolvency by the issuer
           </li>
           <li>marketability
           </li>
           <li>growth of the income
           </li>
         </ul>
       </li>
       <li>
         Income / Running yield
       </li>
       <li>
         Expected return
       </li>
       <li>
         Term
       </li>
       <li>
         Nature
       </li>
       <li>
         Currency
       </li>
       <li>
         Maketability
       </li>
       <li>
         Tax
       </li>
       <li>
         The need to match liabilities
       </li>
     </ul>
   </p>
   <p>Security part: think from the following viewpoints:
  <ul>
    <li>
    The risk of income (dividend, coupon payment, rent, etc)
    </li>
    <li>
     The risk of capital, the volatility of the capital
    </li>
    <li>
      The risk of default.
    </li>
  </ul>  </p>
  <p>
    When the income prospect of an asset is discussed, the following points should be noticed/addressed;
    <ul>
      <li>
        The growth protential of the income. (e.g. grow with averge salary level, grow with some indexes etc)
      </li>
    </ul>
  </p>
  <p>
    Expected return:
    <ul>
      <li>
        Higher expected return results from higher risk premium,or higher expense associated with the sale.
      </li>
      <li>
          Risk premium compansates for higher uncertainty, higher volatility, less marketability, lower ability to hedge the inflation risk, reinvestment risk.
      </li>
    </ul>
  </p>
   </ul>
   Some points:
   <br>
   The reputation of the issuer could affect the attractiveness of such assets.
   <br>
   Most investors are more concerned with the real return achieved on an investment than on the nominal return …
    as this will ensure that purchasing power is maintained over time
    <br>
    Even when holding higher ranking stock, investor should take into account cover on lower priority bonds.
    Problems covering the interest on lower ranking stock will have an adverse affect on the value of all stock issues by the company.


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    Security of income and capital
    <div id="content">
      Money market
      <ul>
        <li>
          Depends on issuer. The shorter the term, the safer the income.
        </li>
        <li>
          Market value very stable
        </li>
      </ul>
      Government Bond:
      <ul>
        <li>
          Security is usually very high, as risk of default is low.
          Although it depends on reputation of government and level of debt,
          as defaults have happened in the past.
        </li>
        <li>
          volatility of capital values
          <ul>
            <li> bond prices fluctuate on a daily basis
            </li>
            <li>long-dated bonds are more volatile than short-dated bonds
            </li>
            <li>however, if held to maturity, such volatility will not be important
            </li>
          </ul>
        </li>
      </ul>
      Corporate Bond:
      <ul>
        <li>
          Compared with government bonds, the security of corporate bonds
          depends on financial position of company issuing security and on type of security issued.
        </li>
        <li>
          Depends on credit rating.
        </li>
        <li>
          Depends on if there is collateral. (unsecured / debenture etc)
        </li>
        <li>
          However, it will also be useful to carry out an accounting analysis of the issuer. In particular:
          <ul>
            <li>
              need to look at terms and conditions of issue and priority ranking of
              stocks ○ for example: interest and capital payments will generally be paid
              to debenture holders before unsecured loan stock holders
            </li>
            <li>
              must be sufficient income to pay interest
            </li>
            <li>
              must also be sufficient assets to repay capital in the event of a “wind up” (
              measured by interest (or income) cover and asset (or capital) cover respectively
              )
            </li>
          </ul>
        </li>
      </ul>
      Equities
      <ul>
        <li>
          security of income will depend on stability of profits and level of dividend cover (ratio of earnings to dividends)
        </li>
        <li>
          if company is wound up, shareholders will receive any residual assets after all
          creditors have been paid … in practice, this is often nothing at all
        </li>
        <li>
          equity prices can be very volatile, even in the short term
        </li>
      </ul>
      Property Market
      <ul>
        <li>
          Security of income depends on
          <ul>
            <li>
              depends on quality of tenant
            </li>
            <li>
              also, significant risk of voids (when property is empty)
            </li>
            <li>
             risk of obsolescence/depreciation will also be important (as this can reduce demand and/or rental income)
           </li>
           <li>
             property investments are also susceptible to government interventions
              (e.g. rent controls), which can reduce returns
           </li>
          </ul>
        </li>
        <li>
           volatility of capital value
           <ul>
             <li>
               <span class="highlight">market value of can vary considerably in long term, however it is
                relatively stable in short term </span>(due to lack of central market, infrequent
                transactions and stable valuation method)
             </li>
             <li>
               where site value represents a significant proportion of total capital value,
               property value will be more secure − offices and town centre retail properties
               usually have higher site values than out-of-town properties/factories
             </li>
           </ul>
        </li>
      </ul>


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    Income / Running yield
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      Money market
      <ul>
        <li>
          The interest rate should be consistent with prevailing short-term interest rate.
        </li>
        <li>
          In the long run, exceed inflation.
        </li>
        <li>
        Often used as part of monetary policy.
      </li>
      </ul>
      In particular, Floating rate notes:
      <ul>
        <li>Similar to short-term, fixed-interest bonds
        </li>
        <li>except that interest is normally paid periodically and set at a margin over a pre-determined market interest rate such as 3 months London Interbank Offered Rate (LIBOR)
        </li>
        <li>Floating rate notes are issued by corporations, governments and building societies and have various different terms to redemption.
        </li>
        <li>The notes are tradable and, despite their coupons being related to the level of short-term interest rates, they need not necessarily be priced at par (or at the redemption level).
        </li>
      </ul>

      Bond
      <ul>
        <li>
          Running yield will usually be higher than from equities.
          Because, for equities and property, future income can be expected to grow

        </li>
      </ul>

      Index-linked bond
      <ul>
        <li>
          coupon and redemption payments linked to RPI (thus, initial (real) yield
          low, but income and capital income should grow over time in line with inflation)
        </li>
        <li>
          All payments have either eight month (old-style) or three month
          (new-style) indexation lag .. therefore no inflation protection during final few months
        </li>
        <li>
          Guaranteed real return if held to maturity.
        </li>
        <li>
          Attractive to investors with long-term real liabilities (e.g. defined-benefit pension schemes and life
           insurers). (The main reasons for issuing ILBs are: many investors are more
           concerned with real returns than with nominal returns; when inflation is high,
           new issues of fixed-interest bonds need to have a high coupon rate; real yields
           on ILBs also provide information about market expectation of future inflation.)
        </li>
      </ul>
      Property
      <ul>
        <li>
          rent can be expected to increase broadly in line with inflation in the long term, but the pattern of
          increases will depend on the frequency of rent review specified in the lease
        </li>
        <li>
          rent reviews will seek to determine the appropriate market rent (or “rack rent”) for the property
          at regular intervals over the term of the lease (e.g. every 5 years)
        </li>
        <li>
          often, rent reviews will be “upwards-only” − thus, rental income for a single property will increase
          in steps every few years − but, a portfolio of properties with a spread of review dates should produce
          a gradually increasing income stream
        </li>
        <li>
          the rental yield (or running yield) on a property varies with the type of business, but is usually
          <span class="highlight">between that available on equities and conventional bond</span>
        </li>
        <li>
          when calculating the rental yield, we use rental income <span class="highlight">net of all management expenses</span>
             and the price of
          the property <span class="highlight">gross of all purchase expenses</span>
        </li>
        <li> why is the rental yield on property usually higher than that on good quality equities? <br />
            price of property will be lower (and, hence, rental yield higher) to compensate for lower marketability
            of property, greater unpredictability in rental growth and fact that rents increase only infrequently
            (whereas dividends should increase annually).
        </li>
        <li>why is the rental yield on property usually lower than that on conventional fixed-interest bonds? <br />
          because of the prospect of achieving a capital gain on property (as a result of anticipated growth in future rental income).
        </li>
      </ul>
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    Expected returns
    <div id="content">
      Money market
      <ul>
        <li>
          The interest rate should be consistent with prevailing short-term interest rate.
        </li>
        <li>
          In the long run, exceed inflation.
        </li>
        <li>
        Often used as part of monetary policy.
      </li>
      </ul>
      Bond market
      <ul>
        <li>
          Ignoring risk of default, nominal return is known with certainty at outset (assuming that bond is held to maturity)
          <ul>
            <li>
              however, in practice, future coupon payments may have to be re-invested on unknown terms
            </li>
            <li>
              also, real return achieved will be eroded if inflation turns out to be higher than expected at date of purchase
            </li>
          </ul>
        </li>
        <li>
          expected return tends to be lower than for equities or property … due to lower risks involved. But, holding conventional bonds when yields are falling may produce high return
        </li>
      </ul>
      What determines the yield of a bond?
      <ul>
        <li>Marketability of the bond
        </li>
        <li>Credit ratings
        </li>
        <li>History of repayment of credit
        </li>
        <li>General quality of management and business and operational risks taken.
        </li>
        <li>income cover
        </li>
        <li>Capital cover
        </li>
        <li>gearing and other accounting ratios
        </li>
        <li>quality of the management
        </li>
        <li>diversification of the company’s activities
        </li>
        <li> marketability of the underlying assets
        </li>
        <li>security and covenants (e.g. on specific assets)
        </li>
        <li>dealing costs (four marks maximum for eight points stated)
        </li>
      </ul>
      Property market
      <ul>
        <li>
           property is less marketable and less secure than ILBs, so would be expected to provide a higher return
        </li>
        <li>
          also, compensation for higher dealing/management costs, risk of obsolescence and only partial inflation hedge
        </li>
      </ul>
    </div>
  </div>

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    Term
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      <ul>
        <li> Money market: less than 1 year
        </li>
        <li>Bond: short-dated (< 5 years) medium-dated (5-15 years) long-dated (greater than 5 years)
        </li>
      </ul>
    </div>
  </div>

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    Nature
    <div id="content">
      Cash, equity, property are real investments.
      <br />
      bonds
      <ul>
        <li>income and capital payments fixed in monetary terms, <span class="highlight">so that higher than exp
          ected inflation will erode the real return obtained</span></li>
      </ul>
      Equities
      <ul>
        <li>
          <span class="highlight">in the long run</span>, equities are a real asset (as dividend income and, hence, capital value should rise in line with inflation)
          <ul>
            <li>
               However, inflation protection is not guaranteed
            </li>
            <li>
              equities are riskier than government FIBs and, thus, would be expected to give a higher return to compensate
              (1) risk of default is higher,
              (2) volatility of both income and capital is higher … also, marketability may be lower.
            </li>
            <li>
              Why might this relationship not hold in the short term?
              <br>
              other factors affecting supply and/or demand for property will also affect rental levels (and, hence, capital values).
            </li>
          </ul>
        </li>
      </ul>
      Property:
      <ul>
        <li>
          property is a real asset (as, in the long term, rental income should increase broadly in line with inflation) … thus, the capital value of a property (which reflects the PV of future rental income) should also in line with inflation
        </li>
        <li>
          however, this is also impacted by the effect of changes in supply and demand
        </li>
        <li>
          why might demand for an office property fall? during a recession, companies will fail and/or downsize. old age (i.e. better offices may open nearby). changes in trends for office locations (town centre vs out-of-town business park). worsening transport links (e.g. closure of nearby station/airport).
        </li>
      </ul>
    </div>
  </div>

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    Currency
    <div id="content">
      <ul>
        <li>
          currency risk for investors who invest in bonds denominated in one currency but have liabilities denominated in another currency
        </li>
        <li>
          bond may be listed in home currency or overseas (e.g. dollar, euro and yen-denominated bonds traded in London)
        </li>
      </ul>
    </div>
  </div>

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    Marketability
    <div id="content">
      High marketability-> <span class="highlight"> low dealing costs, investors can buy and sell large quantities without adversely affecting the price.</span>
      <br />
      For equities, marketability varies enormously from one company to another:
      <ul>
        <li>
          whether the shares are listed (on an exchange) or not … listed shares will tend to much more marketable than unlisted shares.
        </li>
        <li>
          size of company (as measured both by market capitalisation and number of shares in circulation).
        </li>
        <li>
           concentration of shareholders … marketability may be low if shares on concentrated amongst a few large shareholders.
        </li>
      </ul>
      Property market:
      <ul>
        <li>
          property is very unmarketable … it can take a long time to buy or sell and dealing costs are very high
        </li>
        <li>
           the main reasons for this are:
          <ul>
            <li>
              large unit size and property are usually indivisible
            </li>
            <li>
              each property is unique (making them harder to value and reducing demand)
            </li>
            <li>
              no central market with quoted prices … thus, valuations are subjective, infrequent and expensive (meaning that the property market is much less transparent than the equity market)
            </li>
          </ul>
        </li>
      </ul>
    </div>
  </div>

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    Tax
    <div id="content">
      Point worth considering: If the income and capital gains are taxed differently.
    </div>
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    The need to match liabilities
    <div id="content">
      <ul>
        <li>
          Index-linked bonds are used to back real liabilities. e.g. expenses.
        </li>
        <li>
          Fixed-interest bonds are used to match the liabilities that are fixed in norminal terms.
          <br />
          Match the guarantee of with-profit life insurance. <span class="highlight">  More relevant if the liability reserve is calculated with reference to the interest rate of the government bonds</span>
        </li>
        <li>
          Equities are used to back discretionary liabilities. e.g. The future bonus of with-profit policies.
        </li>
        <li>
          If the question is about pension, you need to consider all possible members. (active members, deferred members, pensioners)
        </li>
      </ul>
    </div>
  </div>

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    Others
    <div id="content">
      Quoted versus unquoted shares: riskiness and marketability
      <br>
      In order to obtain a listing, companies have to comply with the exchange’s regulations relating to financial
       reporting and disclosure (which gives investors a measure of protection). Unlisted (or unquoted)
       equities are not subject to the same degree of regulation … and, thus, are usually
       considered to be a riskier investment. Also, listed (or quoted) shares will tend to be much more
       marketable … <span class="highlight">as a willing buyer has to be found for unquoted shares (whereas quoted shares can be
       sold to the market maker). </span>
       <br>
       Equity categorisation
       <br>
       One of the most commonly used categorisations is by industry. practicality +  correlation of investment performance
       <br>
       The main reasons for such categorisations are practicality (i.e. it is not reasonable to expect an analyst to cover every company within a market)
       <ul>
         <li>
           Because factors affecting one company within an industry are likely to be relevant to other companies in the same industry
         </li>
         <li>
           much of the information required for companies in the same industry will come from common sources
         </li>
         <li>
           no single analyst can expect to be an expert in all areas
         </li>
       </ul>
       and correlation of investment performance (i.e. companies within the same industry are often affected by the same external factors, and thus performance within an industry sector is often correlated).
       <ul>
         <li>
           resources – companies in the same industry will use the same resources (e.g. labour, land, raw materials) and, thus, will have similar input costs
         </li>
         <li>
           markets – companies in the same sector supply the same markets and will be similarly affected by changes in demand
         </li>
         <li>
           structure – companies in the same sector often have similar financial structure and exposure to interest rate changes
         </li>
       </ul>
    </div>
  </div>

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  <p> Author: Mengke, Lyu</p>

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